Greenspan Shifts into Neutral...

December 09, 2003

By Michael Wallace The Federal Open Market Committee (FOMC), the Federal Reserve's policy-setting arm, left the Fed funds target rate at a generational low of 1% at its Dec. 9 meeting. No surprise there. The real take-away from the committee's post-meeting statement: Collectively, the Fed is feeling more optimistic on the economy and less pessimistic about deflation risks ahead, according to my reading of the rhetorical tea leaves.

The Fed shifted its policy bias toward neutral, away from the risk that inflation becomes undesirably low as the "predominant concern." The FOMC somehow managed to upgrade its view about the economy's evident strength, while maintaining that "upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal."

CLEARER SIGNS. That was a deft move. In effect, the Fed extended an act of seasonal charity to the markets by avoiding a direct shift in the overall policy bias from weakness to strength. Apparently Fed Chairman Alan Greenspan thought a layover in neutral-policy territory a prudent idea (see BW Online, 12/8/03, "The Fed Can Afford to Be "Patient").

The central bank has clearly taken note of the cheer spreading throughout the economy, relative to the tentative signs acknowledged in the last FOMC statement on Oct. 28. Let's compare the two. "Output is expanding briskly" this time around, whereas spending was merely "firming" last time. "The labor market appears to be improving modestly," compared to just "stabilizing" before.

Moreover, while core consumer prices are tame and expected to remain so, the Fed took a big step away from the deflation abyss. "The probability of an unwelcome fall in inflation has diminished in recent months and now appears almost equal to that of a rise in inflation," the Fed declared in its statement. Thus, the it sees the economic and inflation risks each balanced -- more evidence of neutrality.

RETREAT ON THE STREET. However, the icing on the policy cake was keeping intact the Fed's intention to maintain "policy accommodation for a considerable period." Translation: With inflation still "quite low" and "resource use slack," Greenspan & Co. believes that before considering any rate increases, they have the latitude to let the economy steam along until the output gap narrows significantly.

Yet all this Fed magnanimity and durable commitment to ultralow rates doesn't come free -- in this case, the price is the weaker dollar. The greenback hit a fresh historic low against the euro earlier in the Dec. 9 trading session on the presumption that yield support for the U.S. currency would remain at low ebb. This appeared to give pause to the stock market as well, which sold off "on-the-fact" of the FOMC shift to "neutral" after the Dow Jones Industrial average had briefly flitted above the 10,000 level this week.

The markets' message for the FOMC: While a slow, smooth transition toward higher rates is widely welcome, any sense of benign neglect of its inflation-fighting duties will be received like a lump of coal in the stocking. In this regard, a shift in the policy bias toward tightening in the first quarter of 2004 may yet prove the best prevention for an "unwelcome" uptick in inflation. Wallace, formerly senior market strategist for MMS International, is an independent economic consultant based in San Francisco